Nick Rowe on the Eurozone

Nick Rowe has written an excellent post on the Euro money supply. Here is a long excerpt:

Only the European Central Bank has enough money to fix the Eurozone problem; because it can print it. What’s ironic is that what they call “The Nuclear Option” is what first year economics textbooks describe as the normal way that central banks increase the money supply. We call it “Open Market Operations”. Print money and use it to buy Eurozone government bonds.

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Eurozone commercial banks hold Eurozone government bonds as assets. With the drop in those bonds’ values, many commercial banks (inside and outside the Eurozone) will become insolvent. There will be (and already are) runs on those banks, as depositors seek to transfer their deposits to safer banks, if any can be found, or withdraw currency, if they can’t.

The first year textbook says this fall in bank deposits will cause a fall in the money supply, and that this fall in the money supply will cause a recession. And the general fear of financial assets will also cause an increase in the demand for money which will exacerbate the problem of a declining supply. And the solution is for the central bank to do whatever it takes to increase the money supply by however much it takes to eliminate the excess demand for money.

I don’t see how the ECB will do this, if it can’t buy bonds, can’t lend to insolvent banks, and can’t lend against junk bond colateral.

Instead, the ECB will point to its nice low interest rate target and say “Look how loose monetary policy is!”. And it will be low, because the only people who can borrow at that rate won’t need to, and all those who desperately want to borrow at that rate won’t be allowed to.

The fall in the Euro money supply will cause a worsening Eurozone recession. As I, Scott Sumner, Bill Woolsey, (and others) have been saying all along, central banks’ nominal interest rate targets are not a good measure of the stance of monetary policy.